Shadow Banking System

Abstract

"Shadow banking system" refers to a collection of financial institutions and practices that are outside of the traditional, more regulated banking system. Traditional banks are monitored by the government to ensure that they remain financially sound by not taking on too much risk. Institutions such as investment banks, hedge funds, structured investment vehicles, and off balance sheet securitizations all fall outside of traditional financial regulatory regimes, creating a shadow banking system that has grown large enough to rival the traditional banking system. This exposes the economy to greater levels of risk as was seen in the financial collapse of 2008.

Overview

Traditional banks are more heavily regulated because they are known as deposit banks—that is, they accept deposits from investors, pay interest to the depositor at a specified rate, and then use the investor’s money to make loans and to secure other types of investment. Each such loan made by a bank includes an amount of risk because there is a chance that the borrower will not be able to pay the money back to the bank, leaving the bank in the position of having to cover the loan by using its own assets. If a deposit bank were not required to follow certain rules regulating risk, then the bank might taking on excessive risk to earn money. Carrying too much risk backfires, because when too many of the bank’s loans fail to be repaid, the bank finds itself in the position of having to cover (pay back) more money than it has available in the form of assets. Banking regulations exist to prevent this type of scenario (United States, 2011; Gennaioli, Shleifer & Vishny, 2013).

However, banking regulations were developed to control traditional, deposit banks. Most regulations do not apply to institutions that do not fit into the traditional model of deposit banks, so in order to be able to take on greater amounts of risk and earn higher returns, the financial industry has often developed alternative institutions and higher risk types of investment (e.g., credit default swaps), which are not subject to such strict regulation and often do not need to be included on balance sheet reports of an entity’s financial health. As these alternative institutions have grown in number over the years, they have attracted more and more investors, to the point that the amount of money invested in the alternative, or shadow, banking system rivals that of the traditional banks (Longworth & C.D. Howe Institute, 2012).

This has been a major area of concern because many of the investors in the shadow banking system are traditional financial institutions. This means that even traditional financial institutions are able to take on greater risk than many of their depositors might be comfortable with. The shadow banking system played a major role in the financial collapse of 2008. The collapse was caused by a classic case of institutions taking on excessive amounts of risk. When markets began to correct themselves after several years of inflated housing prices and subprime mortgage lending, several major financial institutions found themselves owing far more money than they had the ability to repay (England, 2011).

Further Insights

Shadow banking institutions had grown so huge and become so diversified by the first decade of the twentieth century, that the failure of one or two of them threatened to bring down other institutions as well, because so many parts of the shadow banking system had become intertwined with one another. Institutions that took on too much risk in the mortgage markets also invested in hedge funds to try to mitigate their risk, but when multiple investors in the mortgage markets lost their investments, then they all sought to recover on their hedge fund investments, causing those to begin to collapse as well.

Through lack of oversight, the shadow banking system became like a set of dominos, so that when one institution fell it brought down others, which threatened to bring down others, and so on. This is precisely the kind of scenario that banking regulations are set up to prevent, and ultimately the federal government had to step in and provide enough cash to prop up the economy, preventing a complete collapse. After these events, calls for greater regulation of the shadow banking system were renewed and intensified (Haugen & Musser, 2011).

A major complaint about the shadow banking system has long been that it exists primarily because of the close relationships between the leaders of major financial institutions and the government. Critics of this system complain that it operates like a revolving door: government employees charged with implementing and enforcing financial regulations often spend a few years working for the government, and then resign to enter the private sector, taking very high paying positions with the very companies that they previously regulated.

These companies—many of whom operate or invest in major players in the shadow banking system—benefit from the former government employees’ knowledge and connections, often allowing them to discover new ways of increasing revenue by avoiding regulatory scrutiny (Hirsch, 2012). Furthermore, it is common practice for the heads of government agencies in charge of financial regulation to be drawn from the ranks of banking executives, leading some to observe that the revolving door turns in both directions. The problem with this, according to critics of the system, is that finance executives and government regulators becomes so intertwined with one another that no one wants to disrupt the ecosystem by creating and enforcing financial regulations that are tough enough to curtail the problematic practices of the shadow banking system. Doing so would harm one’s career prospects by interfering with the investment goals of future employers.

For example, an employee at a government agency charged with supervising shadow banking activities is in a position to push for greater oversight of investment banks. However, if this employee knows that in the near future he or she can quit a government job and go work for one of these investment banks, then it is not in his or her interest to inconvenience the investment banks. This type of scenario has led some to suggest that the best way to begin regulating the shadow banking system is by putting in place regulations that would require the passage of a certain amount of time after employees leave government service before they can take a position with private investment firms, and vice versa (Luttrell et al., 2012).

Viewpoints

Economic theorists point out that the activities of the shadow banking system are not problematic in and of themselves, but become so because they are largely unregulated. The financial markets operate on basic principles of supply and demand capitalism, and investment resources that are not required to be asset backed will tend to flow toward investment vehicles that offer the largest potential returns (Annual International Banking Conference, & Claessens, 2015). In the modern context, this explains why investments in the shadow banking system have tended to increase over the years, to the point where they rival investments in traditional deposit banks (Nesvetailova, 2015).

The primary way to combat this trend is by implementing regulations that require activities in the shadow banking system to follow risk allocation requirements similar to those that exist for deposit banks. Doing this, it is thought, will decrease incentives for capital to flow into the shadow banking system, because if shadow banks are no longer permitted to take on inordinate amounts of risk, then they will likewise be unable to earn the rewards that up until now have made the risk so attractive.

Supporters of this approach point out that shadow banks do most of the same types of things as traditional banks, so it is only fair that they should be subjected to the same types of regulations. There is also historical precedent for enacting such reforms. In 1933 the Glass-Steagall Act placed limits on the types of investments that deposit banks could enter into, in the hope of protecting consumers against banks’ practice of increasing their own profits by investing depositors’ money in risky ventures. Over time, the Glass-Steagall Act was gradually weakened through prolonged lobbying efforts by the financial sector of the economy, until it was repealed in 1999 (Jenkins & Collins, 2012).

Some economists have suggested that the gradual erosion of many of Glass-Stegall’s protections was what made possible the financial collapse of 2008, concluding that it therefore makes sense to reinstate such protections as a means of preventing similar disasters in the future. Critics of such regulations, most of them with ties to the financial sector, point out that free markets can only function well when they are truly free, that is, not bound by excessive government regulation, but able to use their own creativity, ingenuity, and financial acumen to maximize profits (Akerlof, 2014). Plantin (2014) argues that regulation of the banking sector drives capital investment to shadow institutions.

The Dodd-Frank Wall Street Reform and Consumer Protection Act was passed into law in 2010 as a response to the economic collapse of 2008. Some of its provisions include greater oversight of derivatives (complex financial instruments that can lead to unforeseeable amounts of risk). The act fell far short of what critics of the financial industry called for, however. A legislative compromise that affords protection to traditional banking consumers and the economy at large, while still offering higher risk investment opportunities for banks and similar institutions, continues to be sought in Congress. Parties on both sides hope that some type of agreement can be reached before the next financial crisis rears its head, though with the speed and interconnectedness of the modern global economy, it is far from certain that this will be possible (Guttmann, 2015).

Terms & Concepts

Balance Sheet: A balance sheet is a listing of assets and liabilities that acts like a report card showing the overall health of a financial institution.

Credit Default Swaps: A credit default swap is an investment vehicle involving an agreement between two parties to take some action in the event that a specified loan is defaulted upon. The seller and buyer of the credit default swap agree in advance that, if the loan defaults, then the seller of the credit default swap will compensate the buyer. Interestingly, there is no requirement for either seller or buyer to be financially obligated by the loan. Credit default swaps were one of the questionable investment strategies used by financial institutions to over leverage themselves in the years leading up to the financial collapse of 2008.

Dodd-Frank Act of 2010: The full name is the Dodd-Frank Wall Street Reform and Consumer Protection Act. It was passed into law in 2010 as a response to the economic collapse of 2008. Some of its provisions include greater oversight of derivatives (complex financial instruments that can lead to unforeseeable amounts of risk), measures to protect consumers by simplifying financial agreements and creating a new agency to respond to consumer complaints, and implementing some measures to help the country prepare for future financial crises and respond more quickly when they occur.

Hedge Funds: A hedge fund is a type of financial investment that was originally designed to help investors protect against, or "hedge" against, risk. Hedge funds are essentially large conglomerations of other investments—sometimes large numbers of very diverse investments. The first hedge funds mitigated risk by including instruments that took both long and short positions on the same investment. The long position functions like a bet that the stock price will go up, while the short position functions like a bet that it will fall. Risk is hedged because no matter what the stock price does, the investor receives some financial return. The financial crisis of 2008 was largely related to the widespread failure of subprime mortgages (mortgages made to borrowers unlikely to be able to afford the payments), and there was considerable controversy about the practice of many mortgage lenders authorizing loans and then using hedge fund investments to basically bet against those loans being paid off.

Off Balance Sheet Securitizations (OBSS): Investment banks are subject to financial regulations and reporting requirements to make sure that their investment decisions are sound and do not expose the bank and its investors to unsustainable levels of risk. However, it has long been possible for these investment banks to conduct some of their business in ways that fall outside of the reporting requirements they must follow, so that some transactions do not legally need to be included on the bank’s. Securitization is simply the financial practice of pooling different forms of debt; off-balance sheet securitization amounts to investment banks finding ways to avoid the inclusion of some of the debt they carry on the bank’s balance sheet. This has the effect of making the bank appear to be in a much better financial position than it actually is.

Structured Investment Vehicle: Structured investment vehicles are financial institutions that were first used in the late 1980s by Citigroup. Structured investment vehicles earn money by using a credit spread: They acquire capital from an initial pool of investors and then use this capital to make short- and medium-term loans. Income from these activities is then used to acquire long-term securities at higher rates. From the perspective of large financial institutions, the main advantage offered by structured investment vehicles is that they often do not need to be included on the institution’s balance sheet, making them similar to off balance sheet securitizations.

Bibliography

Akerlof, G. A. (2014). What have we learned?: Macroeconomic policy after the crisis. London, UK: MIT Press.

Annual International Banking Conference, & Claessens, S. (2015). Shadow banking within and across national borders. Hackensack ,NJ: World Scientific.

England, R. S. (2011). Black box casino: How Wall Street's risky shadow banking crashed global finance. Santa Barbara, CA: Praeger.

Gennaioli, N., Shleifer, A., & Vishny, R. W. (2013). A model of shadow banking. Journal of Finance, 68(4), 1331–1363. Retrieved January 12, 2016 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=89079594&site=ehost-live

Guttmann, R. (2015). Finance-led capitalism: Shadow banking, re-regulation, and the future of global markets. New York, NY: Palgrave Macmillan.

Haugen, D. M., & Musser, S. (2011). Reforming Wall Street. Detroit, MI: Greenhaven Press.

Hirsch, P. (2012). Man vs. markets: Economics explained (plain and simple). New York, NY: HarperBusiness.

Jenkins, D. A., & Collins, M. I. (2012). Shadow banking and its role in the financial crisis. Hauppauge, NY: Nova Science.

Longworth, D., & C.D. Howe Institute. (2012). Combatting the dangers lurking in the shadows: The macroprudential regulation of shadow banking. Toronto, Ontario: C.D. Howe Institute.

Luttrell, D., Rosenblum, H., Thies, J., & Federal Reserve Bank of Dallas. (2012). Understanding the risks inherent in shadow banking: A primer and practical lessons learned. Dallas, TX: Federal Reserve Bank of Dallas.

Nesvetailova, A. (2015). A crisis of the overcrowded future: Shadow banking and the political economy of financial innovation. New Political Economy, 20(3), 431–453. Retrieved January 12, 2016 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=102275069&site=ehost-live

Plantin, G. (2015). Shadow banking and bank capital regulation. Review of Financial Studies, 28(1), 146–175. Retrieved January 12, 2016 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=101033403&site=ehost-live

United States. (2011). The financial crisis inquiry report: Final report of the National Commission on the Causes of the Financial and Economic Crisis in the United States. New York, NY: Public Affairs.

Suggested Reading

Batchvarov, A. (2013). Parallel, rather than "shadow," banking system. Journal of Risk Management in Financial Institutions, 6(4), 346–351. Retrieved January 12, 2016 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=91895977&site=ehost-live

Culp, C. L. (2013). Syndicated leveraged loans during and after the crisis and the role of the shadow banking system. Journal of Applied Corporate Finance, 25(2), 63–85. Retrieved January 12, 2016 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=90181273&site=ehost-live

Kelemen, V. (2014). Shadow banking and U.S. financial regulatory policy: Overviews. New York, NY: Novinka.

Prates, D. M., & Farhi, M. (2015). The shadow banking system and the new phase of the money manager capitalism. Journal of Post Keynesian Economics, 37(4), 568–589. Retrieved January 12, 2016 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=108954710&site=ehost-live

Sunderam, A. (2015). Money creation and the shadow banking system. Review of Financial Studies, 28(4), 939–977. Retrieved January 12, 2016 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=110084342&site=ehost-live